The Agency Problem, Stock Market Manipulation, and Enron

Although CEOs are usually considered bosses, not employees, they are in fact employees of the stockholders. Like all employees, they have an incentive to put their interests above those of their employers. On her web site, www.JaneGalt.net, Megan McArdle provided a highly readable analysis of this issue.^[6] Since she’s letting me use her writings for free (I’m greedy), and even approximating her level of quality would require my putting in tremendous effort (I’m lazy), I quote her at length.

The agency problem is the fancy economic term for what most of us already knew intuitively; what benefits the stockholders doesn’t necessarily benefit management. For example, I can think of many executives I’ve worked with on “re-engineering” projects, who, if they wanted to be honest about what would make their department work better, would “re-engineer” themselves right out the door and let somebody competent take over. Somehow, however, it was always one of their minions, usually one they didn’t like too well, who was found to be superfluous. There are all sorts of ways in which this agency problem affects managers’ actions to the detriment of their shareholders, but one of the most widely known is in compensation.

If you know anyone in corporate sales, you probably already know of the hilarious shenanigans in which the sales force engages in order to meet their quotas. The purchasing manager at my old job was good for 10K or so of thoroughly bogus orders at the end of the month or the quarter to help our sales reps meet their quotas; in return they gave us a little extra off our regular purchases. These orders were invariably cancelled, after a decent interval, due to the whims of our fictitious clients. None of this was good for the companies for whom these sales reps worked; it benefited only the sales force.

But trying to prevent these gymnastics has proved futile. Change the quota from orders to sales and they’ll ship the stuff out and have it “returned,” incurring shipping charges both ways; change sales to “final sales” and they’ll leave, because no one’s willing to have their income that dependent on the whims of people they don’t know. This applies even more to executives, who have much more power to manipulate matters so that they keep their job.

Now, being say, the CFO, is inherently riskier than being a clerk in accounting. It may not seem like it, but really, at the lowest level of a corporation, all you have to do in many jobs is show up on time and breathe. Even the most incompetent CFO gets made responsible for a lot of stuff, some of it out of his control, and not all of which can be blamed on his subordinates. If enough things go wrong, he’ll be fired. This is why most senior executives spend so little of their time doing anything that looks like work to the clerks in accounting, and so much of their time sucking up to the board.

So executives do anything in their power to minimize that risk. Often, this makes them unwilling to make risky but high-expected value choices, because a bad bet could cost them their jobs. At other times, such as when the company is on the rocks, it makes them prone to shoot the moon on highly speculative ventures because, what the hell, they’re going to lose their job anyway, so why not plunge all the firm’s assets into that deep-sea titanium mining venture and hope they strike it rich? Entire consultancies, like Stern Stewart, have evolved around various metrics for structuring compensation so that the managers either get rich with the shareholders, or go down with the ship.

One of the original ideas was the bonus, predicated on performance. Of course, you can’t just say “performance”; you have to give a metric, or a combination of them, that dictates what performance is. And there’s the rub. They tried all sorts of things. If revenue growth was used, you got revenue growth—but much of that revenue was unprofitable, as the executives slashed margins to move product. Tell them to cut costs, and they’d stop making stuff to sell. Tell them they had to improve net income, and games were played with the financial statements to maximize net income.

So what became popular? Stock price. Seemed perfect; put the bulk of an executive’s compensation in company stock, and watch those incentives align!

Well, not quite.

First of all, notice that all those managers made out like bandits in the recent bull market, even though they probably contributed little to its root causes, such as good monetary policy and the conviction of the American public that they’d finally found a sure thing. (Although probably a lot of them helped found their company’s 401K, so perhaps we should give them some of the credit.)

Second of all, stock prices are . . . ahem . . . not immune to manipulation. No! I hear your stricken cry, Tell me it isn’t so, Jane! Say it ain’t so! But I’m afraid I cannot, my little chickadees. Stock prices do not represent some platonic ideal of the actual, true, total current, and future value of the company; they represent the market’s idea of that value, which is something very different. Thus, they can be manipulated.

If you’ve wondered why all the Enron executives seemed to have such outsized amounts of stock given in consideration for doing nothing but sitting in meetings all day talking about what a great company Enron was, this is why. And if you’ve wondered why they played all those games with the company’s income, this is also why.

Share price is determined in large part by analysts. Analysts like certain things in certain types of companies. In Enron’s case, they liked things like rapid growth, both in asset base and earnings. They liked them a lot. So much, in fact, that the executives knew that unless they continued to produce this growth, the next time the analysts went up on the mountain where God delivers the share prices to them on stone tablets, the burning bush would deliver a punishing verdict that would send Enron’s stock price, and hence the executives’ incomes, falling.

Now, the first time they fudged the numbers, it probably seemed innocuous; just smoothing out a little dip this quarter. The problem is, the more quarters the rising income went on, the more the analysts grew to expect it, and the worse the punishment if they failed to deliver. Thus the ever-expanding web of deception that has now ensnared us all in a gray future of mediocre returns and endless congressional hearings on exciting topics like foreign earnings deductions. But I digress.

We’re now seeing more and more such items hit the headlines; Xerox is the latest perp, and the charges are a predictable m lange of little accounting fudges here and there which together conspired to wildly misrepresent the state of the company’s earnings. Which brings up two interesting points.

The first is that economists and financial wizards got it wrong. The best minds of a generation convinced themselves, to some extent, that the law of unintended consequences would not apply to something as obvious as stock-based compensation. It’s a healthy reminder that no matter how good an economic idea seems, we should always try to figure out how we’d manipulate the system, if it were us.

The second is that it’s easy for us all to say that we wouldn’t have done the same thing in the place of those Enron executives. And from the safety of my little closet on the Upper West Side that’s an easy call; no one’s yet offered me hundreds of millions worth of stock for ranting at you guys all week. But try to think of it another way: if you could have half your income taken away unless you delivered a growing number of whatever it is you make, be it computer programs or payroll reports, every single quarter, you’d be pretty desperate to make that number grow, wouldn’t you? When you hit the natural limits of your ability to produce those programs or reports, and it was a choice between lying to the bean counters or telling your wife to cancel that vacation to the Bahamas and plan on spending the week re-painting the house, it might not be so hard to convince yourself that a little fudging, just this once, wouldn’t hurt.

So it’s back to the drawing board on executive compensation. Which is the beauty of capitalism, really. We got it wrong this time. It may take us a few more tries to get it right. But we don’t expect to set up the perfect system once and for all; capitalism is just the system for finding the perfect system. So when something goes wrong, the almost-instant response is “we’re working on it.”

^[6]Posted on April 12, 2002, and printed here with her permission.